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Fair Value (U.S. GAAP) and Entity-Specific (IFRS)Measurements for Performance Obligations: ThePotential Mitigating Effect of Benchmarks on EarningsManagementCheri R. Mazza a , James E. Hunton b & Ruth Ann McEwen ca John F. Welch School of Business , Sacred Heart Universityb Bentley Universityc Florida International UniversityPublished online: 10 Jun 2011.

To cite this article: Cheri R. Mazza , James E. Hunton & Ruth Ann McEwen (2011) Fair Value (U.S. GAAP) and Entity-Specific(IFRS) Measurements for Performance Obligations: The Potential Mitigating Effect of Benchmarks on Earnings Management,Journal of Behavioral Finance, 12:2, 68-77, DOI: 10.1080/15427560.2011.575969

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JOURNAL OF BEHAVIORAL FINANCE, 12: 68–77, 2011Copyright C© The Institute of Behavioral FinanceISSN: 1542-7560 / 1542-7579 onlineDOI: 10.1080/15427560.2011.575969

Fair Value (U.S. GAAP) and Entity-Specific (IFRS)Measurements for Performance Obligations: The

Potential Mitigating Effect of Benchmarks onEarnings Management

Cheri R. MazzaJohn F. Welch School of Business, Sacred Heart University

James E. HuntonBentley University

Ruth Ann McEwenFlorida International University

A total of 86 financial managers participated in an experiment designed to assess the reliabilityof Level 3 fair value (U.S. GAAP) and entity-specific (IFRS) measurements of performanceobligations. The study focuses on asset retirement obligations because, to date, under U.S.GAAP they are the sole performance obligation measured at fair value. The findings indicatethat with a benchmark, managers tend to manage earnings less with fair value measurementsthan entity-specific measurements. In contrast, without a benchmark, managers tend to manageearnings irrespective of whether the obligation is measured using fair value or entity-specificvalue. Findings suggest that to the extent IFRS entity-specific measurements are associatedwith internally derived benchmarks, they may be more reliable than Level 3 fair value U.S.GAAP measurements that will not have benchmarks.

Keywords: Fair value, Entity-specific, Asset retirement obligation, Earnings management,Benchmark

INTRODUCTION

Archival research related to financial items indicates thatfair value measurements are most relevant and reliable whenthe items are associated with active exchange markets (e.g.,Carroll et al. [2003], Barth [1994], Petroni and Wahlen[1995], Barth et al. [1996], Eccher et al. [1996], Nelson[1996]). Due to unease about the reliability of fair valuemeasurements for financial items traded in thin markets,the Financial Accounting Standards Board (FASB) in 2008issued interpretive guidance in the form of FASB StaffPosition, No. 157-3, Determining the Fair Value of a

Address correspondence to Ruth Ann McEwen, Director, School ofAccounting, Florida International University, 11200 SW 8th Street, RB210, Miami, FL 33199. E-mail: rmcewen@fiu.edu

Financial Asset When the Market for That Asset is Not Active.In the context of fair value for nonfinancial items, concernsarise because by their nature they lack active markets; hence,their valuations are based solely on unobservable cash flowinputs.

The current study focuses on the reliability of Level 3 fairvalue measurements for performance obligations. We useliabilities for asset retirement obligations (AROs) resultingfrom FASB Statement No. 143, Accounting for Asset Retire-ment Obligations, because, to date, they are the only per-formance obligation measured at fair value (FASB [2001]).We assess reliability in the context of earnings managementbecause opportunities exist for manipulation when the ulti-mate cash settlement is different from the carrying amountof the liability resulting from the application of Statementof Financial Accounting Standards (SFAS) No. 143. Amongother things, the ultimate cash settlement could be lower due

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POTENTIAL MITIGATING EFFECT OF BENCHMARKS 69

to the requirement to include profit margin and market riskin the fair value measurement.

We also investigate the potential impact of InternationalFinancial Reporting Standards (IFRS) on the tendency ofmanagers to manipulate earnings via ARO liability measure-ments. Under IFRS guidance provided by IAS 37 [1998],Provisions, Contingent Liabilities and Contingent Assets, ini-tial measurement of an ARO is provided by management’sbest estimates. Paragraph 37 states that the best estimate isthe amount than an entity would rationally pay to settle theobligation at the end of the reporting period or transfer it toa third party at that time.

We use an experiment to address our study hypothesisand research questions. The experiment includes a total of86 financial executives. It assesses whether a benchmark inthe form of a comparable market price for a fair value mea-surement tempers earnings management potential (H1). Inaddition, it relaxes the requirements of SFAS No. 143 to as-sess two research questions (RQs) related to fair value versusentity-specific measurements. RQ1 examines whether fairvalue and entity-specific measurements are equally prone toearnings management in the absence of benchmarks, andRQ2 studies whether both measurements are equally subjectto earnings management in the presence of benchmarks.

Research results indicate that a comparable benchmarksignificantly dampens earnings management for fair valuemeasurements. Furthermore, with a benchmark, fair value isless prone to earnings management than entity-specific, pre-sumably because of the external nature of the benchmark forfair value. In contrast, without a benchmark fair value andentity-specific measurements are equally prone to earningsmanagement. Thus, to the extent IFRS entity-specific mea-surements are associated with internally derived benchmarksthey may be more reliable than Level 3 fair value U.S. Gen-eral Accepted Accounting Principles (GAAP) measurementsthat will not have benchmarks.

BACKGROUND, HYPOTHESES ANDRESEARCH QUESTIONS

SFAS No. 143 requires entities to recognize and measureARO liabilities at fair value defined by SFAS No. 157 as “theprice that would be paid to transfer a liability in an orderlytransaction between market participants at the measurementdate” (FASB [2006], paragraph 5).1 Ideally, fair value wouldbe obtained from a market price. However, because marketsfor AROs generally do no exist, an expected present valuetechnique would usually be the only appropriate techniqueto estimate fair value (FASB [2001]). In the hierarchy estab-lished by SFAS No. 157, fair value measurements of ARO li-abilities reflect Level 3 measurements because they are basedon unobservable inputs. Level 3 measurements are given lesspriority and therefore are considered less reliable than Level1 measurements, which are based on quoted prices in activemarkets.

SFAS No. 143’s requirement for a fair value measurementstems from the decision in Statement of Financial AccountingConcepts (SFAC) No. 7 to require fair value as the sole at-tribute for any measurement using present value techniques(FASB [2000]). However, in one of two Exposure Draftsleading to SFAS No. 143, the Board considered requiring anentity-specific measurement defined as the “present value ofthe estimated future cash outflows that will be required tosatisfy the asset retirement obligation” (FASB [1996], para-graph 11). At that time, an entity-specific measurement wassupported by the first of two Exposure Drafts leading to SFACNo. 7, in which the FASB indicated that “an entity-specificmeasurement may be appropriate in some situations, and thatit will evaluate whether to require fair value or entity-specificmeasurement on a project-by-project basis” (FASB [1997],paragraph 42). However, in the second (revised) present valueExposure Draft (FASB [1999]) and ultimately in SFAC No.7 (FASB [2000]), the FASB concluded that it could not iden-tify any situation in which an entity-specific measurementobjective provided more relevant information than fair valueand concluded that fair value provides the most completeand representationally faithful measurement of the economiccharacteristics of an asset or a liability.2

Relevance and Reliability of Fair Value

Relevance and reliability are the two primary criteria theFASB uses for choosing among accounting alternatives. Inarchival studies, academics usually operationalize the rel-evance/reliability criteria by investigating whether an ac-counting amount has a predicted significant relation withshare prices. An accounting amount will have a predictedsignificant relation with share prices only if the amount re-flects information relevant to investors in valuing the firm andis measured reliably enough to be reflected in share prices(Barth et al. [2001]). Value relevance research relating tofair value includes studies related to investments in debt andequity securities, bank loans, off-balance sheet items, andcertain nonfinancial assets. To our knowledge, there is noresearch relating to the relevance/reliability of fair value fornonfinancial liabilities, such as performance obligations.

Studies examining the relevance of fair value for varioustypes of financial instruments include Barth [1994], Petroniand Wahlen [1995], Carroll et al. [2003], Eccher et al. [1996],Nelson [1996], and Barth et al. [1996]. With the exceptionof Nelson [1996], these studies generally find the fair valueof financial instruments to be value relevant. On whole, thestudies indicate a stronger association with share prices forsecurities traded in active markets versus those traded inthin markets, presumably because of the reliability of themeasurements for the former versus the latter.

Evidence with regard to the relevance of fair value fornonfinancial assets is scant and most recently related to U.S.firms. Compared to financial instruments, the reliability ofestimates for nonfinancial assets is of concern because, for

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the most part, no market exists for these assets. Non-U.S.studies on the relevance of fair value for nonfinancial assetsare related to firms in Australia and the United Kingdom,where GAAP permits companies to revalue assets such asintangibles and property plant and equipment (Barth andClinch [1998], Aboody et al. [1999], Dietrich et al. [2000]).In general, the studies find a significantly positive relationwith share prices, indicating that the estimates of the fairvalues are reliable.

Barth and Landsman [1995] suggest that entity-specificvalue may be more relevant than fair value for assets andliabilities without active exchange markets.3 They assert thatunless estimation error4 is severe, value-in-use (an entity-specific value) is more appropriate for firm valuation forgoing concerns than exit value (fair value) because value-in-use captures total firm value associated with an asset or aliability, including intangibles relating to management skill.

Earnings Management and Fair ValueMeasurements

Schipper [1989] defines earnings management as nonneutralfinancial reporting in which mangers intervene intentionallyin the financial reporting process to produce some privategain. Earnings management includes situations in whichmanagers use judgment in financial reporting to alterfinancial reports so as to influence contractual outcomes thatdepend on reported accounting numbers (Healy and Whalen[1999]). Watts and Zimmerman [1978] suggest that manage-ment compensation contracts create incentives for earningsmanagement because it is likely to be costly for compensationcommittees and creditors to “undo” earnings management.Several studies find that compensation contracts induce somefirms to manage earnings to increase bonus awards (Guidryet al. [1999], Healy [1985], Holthausen and Leftwich[1983]). Fields et al. [2001] indicate that rational managerswould not be likely to engage in earnings management inthe absence of expected benefits, and such benefits requirethat at least some users of accounting information be unableor unwilling to disentangle its effects.

With respect to earnings management and fair value, wecontend that the measurement guidance for Level 3 mea-surements in SFAS No. 157 (FASB [2006]) combined withSFAS No. 143 (FASB [2001]) falls into the category of theunstructured and imprecise category of standards analyzed byNelson et al. [2002], who find that managers are more likelyto attempt (and auditors are less likely to question) earningsmanagement under such standards compared to more precisestandards. Thus, under some circumstances, performance-based incentives might motivate managers to use the flexibil-ity afforded by Level 3 fair value measurements to producebiased and unreliable estimates. In a study related to Level3 fair value measurements of impairment losses, McEwen etal. [2008] find that financial analysts expect firm managersto take advantage of discretionary valuation judgments when

assessing the fair value of nonfinancial assets and liabilities,particularly when the lack of an active exchange market ob-fuscates some of the key valuation assumptions. Nonetheless,even though analysts express concern about management bi-ases in making such estimates, they tend to ignore the biasesin the measurement of impairment losses when it furtherstheir own self-interests related to stock price valuation as-sessments about the company.

In their comment letter to the FASB, the Financial Ac-counting Standards Committee of the American AccountingAssociation expressed concern about the reliability and earn-ings management implications of fair value measurementswhen there are no active exchange markets (AAA [2005]).The committee indicates that research evidence generallysuggests that disclosed fair value estimates for financial in-struments include differing levels of reliability, and that thevariation in reliability is related to the extent to which fairvalue estimates include publicly observed market-based in-formation versus management-produced fair value estimates.Likewise, in its response to the FASB on fair value measure-ments, the Committee on Corporate Reporting (CCR) of Fi-nancial Executives International (FEI)5 voice concern aboutfair value measurements for nonfinancial assets and nonfi-nancial liabilities, indicating that such measurements do notfaithfully represent the economic reality of the underlyingtransactions to which they relate (CCR [2005]).

Effect of Benchmarks on Earnings Management

Academic research indicates that fair value amounts are morerelevant and reliable when there are active exchange marketsfrom which to verify the measurements. Furthermore, thepresence of a benchmark makes it more likely that userscould disentangle the effects of earnings management at-tempts. Thus, for nonperformance obligations measured atfair value, we assert that the presence of a comparable marketprice will serve as a benchmark that will dampen the tendencyfor managers to choose liability amounts that would resultin earnings amounts that serve their self-interest. Therefore,we hypothesize the following with regard to earnings man-agement and fair value measurements for ARO liabilities:

Hypothesis One (H1): When deciding on the fair valueamount for an ARO liability and faced with a dilemma ofchoosing between self-interest and company-interest, finan-cial executives with a performance-based bonus plan will(will not) choose an amount that serves their self-interest inthe absence (presence) of a comparable market price, whichserves as an externally verifiable benchmark.

Barth and Landsman [1995] and FASB constituent groupsincluding the American Accounting Association (AAA)[2005] and CCR [2005] indicate that an entity-specific mea-surement may be more relevant than fair value for nonper-formance obligations. To the extent relevance is related tothe reliability of the measurement, we question whether an

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entity-specific measurement will discourage earnings man-agement attempts relative to a fair value measurement. Ifso, we also question whether an externally verifiable bench-mark for the fair value measurement and an internally ver-ifiable benchmark for the entity-specific measurement willbe equally effective at tempering earnings management at-tempts. That leads us to the following research questions:

Research Question One (RQ1): In the absence of a compa-rable benchmark for an ARO liability, are entity-specific andfair value measurements equally prone to earnings manage-ment?

Research Question Two (RQ2): In the presence of a compa-rable benchmark for an ARO liability, are entity-specific andfair value measurements equally prone to earnings manage-ment?

EXPERIMENT

H1 examines whether a comparable benchmark tempersearnings management attempts for fair value measurements.In addition, we compare entity-specific and fair value mea-surements in the following manner: RQ1 addresses entity-specific and fair value measurements when there are no com-parable benchmarks, and RQ2 addresses entity-specific andfair value measurements when there are comparable bench-marks.

Method

The experiment involved a randomized, two-factor, between-participants design, where the treatments were measurementtype (fair value or entity-specific) and benchmark (absent orpresent). The participants were experienced financial man-agers representing medium, large and very large companies,all listed on U.S. stock exchanges, who were attending aninternational financing seminar held by a major financial in-stitution. At the beginning of the seminar, they were asked tovolunteer to participate in a research study about “accountingfor asset retirement obligations.” There were a total of threeone-half day seminars held in three different cities across theUnited States. The seminar leader, who was qualified by theresearchers in how to administer the experimental materials,was unaware of the experimental treatments.

At the beginning of each training session, the seminarleader handed two sealed envelopes to each participant.6 Par-ticipants opened the first envelope and removed the materials.After the participants read the cover sheet and consent form,they read the case materials, responded to a case question,and placed all materials into and sealed the first envelope. Thesecond envelope included a series of manipulation check, de-briefing questions, and demographic information. The trainerdid not allow participants to reopen the first envelope once thesecond envelope was open. As an incentive to participate, the

researchers provided each manager with a $50 contributionto the charity of his/her choice.

The Case

Participants first read background material about a com-pany called MMH Corporation, a manufacturer and distrib-utor of a variety of products across a broad range of indus-tries. The case described a situation where MMH had builta special-purpose manufacturing support facility. Upon ex-piration of the land lease, MMH needed to tear down thefacility, remove waste and hazardous materials, and restorethe land to reusable condition. The participants learned thatMMH must recognize an ARO liability under the provisionsof SFAS No. 143 (FASB [2001]), the basics of which weredescribed in the case materials.

The Treatments

Participants in the entity-specific condition were asked toassume that SFAS No. 143 requires companies to measure theliability for an ARO using an entity-specific measurement,the details of which were fully explained. They were pro-vided with the choice of two entity-specific liability amounts($8.2 million and $9.0 million). Participants in the fair valuecondition were asked to assume that SFAS No. 143 requirescompanies to measure the liability for an ARO at fair value,the details of which were fully explained. They were pro-vided with the choice of two fair value liability amounts($10.4 million and $11.5 million). In all conditions, partic-ipants were informed that the staff, which was experiencedwith SFAS No. 143 liability measurements, had calculatedand recommended the respective lower liability amounts($8.2 million for entity-specific and $10.4 million for fairvalue).

In the entity-specific treatment, participants with no inter-nal benchmark further read: “The cost management depart-ment has not prepared its projections for this liability. There-fore, there is no projection to aid in your decision about theamount of the ARO liability.” On the other hand, participantswith an internal benchmark read: “The cost management de-partment has prepared its projections for this liability. The$8.2 million liability is more comparable to the projectionthan the $9.0 million liability.”

In the “fair value with no comparable market price” treat-ment, participants read the following: “There are no activeexchange markets for the assumption of ARO liabilities.Therefore, there are no comparable market prices on whichto base your decision about the amount of the ARO liability.”In the “fair value with comparable market price” treatment,participants further read the following: “There are active ex-change markets for the assumption of ARO liabilities. Inthose markets $10.4 million is more comparable to MMH’sARO liability than $11.5 million.”

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TABLE 1Entity-Specific Financial Information

Assume that you are the controller of MMH Corporation and that MMH will use its own internal resources (labor, materials, overhead) to tear down thesupport facility.

It is December 31, 2007 and for external reporting purposes you must decide on the initial amount of the ARO liability for the support facility describedabove. You are deciding between two amounts: $8.2 million (staff recommendation) and $9.0 million.

Your staff, which is experienced in calculating measurements of this type, provided the following details related to its recommendation for an $8.2 millionentity-specific liability:

Cash Flow Scenario

($000)Component

A B C Total

MMH’s estimated cash flows for labor, materials, and overhead. $7,909 $9,006 $10,661Probability of scenario .333 .333 .333Probability-weighted estimated cash flows $2,610 $2,972 $3,518 $9,100Adjustment for risk (9%) 819Total expected cash flows 9,919Entity-specific ARO liability $8,235

The $8.2 million liability would result in the following financial statement results:

ARO liability $8.2 million(Amounts in $millions) 12/31/07 12/31/08 12/31/09Estimated earnings before ARO-related items $55.0 $63.0 $67.0Effect of ARO on earnings (interest and depreciation) N/A (4.9) (5.0)Estimated gain at settlement .8Earnings net of ARO items $55.0 $58.1 $62.8Earnings trend over previous year after ARO items 105% 106% 108%Debt-equity multiplier 1.8 1.9 1.8

You are considering whether you could increase the $8.2 million liability to $9.0 million, which would result in a significantly higher gain at settlement andthe following financial statement results:

ARO liability $9.0 millionAmounts in $millions) 12/31/07 12/31/08 12/31/09Estimated earnings before ARO-related items $55.0 $63.0 $67.0Effect of ARO on earnings (interest and depreciation) N/A (5.4) (5.5)Estimated gain at settlement 1.8Earnings net of ARO items $55.0 $57.6 $63.3Earnings trend over previous year after ARO items 105% 105% 110%Debt-equity multiplier 2.0 2.1 1.8

Tables 1 and 2 include details about the financial informa-tion provided to the entity-specific and fair value participants,respectively.

As shown in Tables 1 and 2, the entity-specific liabilityamounts ($8.2 million and $9.0 million) are lower than thefair value liability amounts ($10.4 million and $11.5 million)due to the absence of two cash flow components requiredto measure fair value: (a) adjustment for market amountsthat are different from entity-specific amounts; and (b) profitmargin. However, the amounts and probability assessmentsassociated with the cash flow component for labor, materialsand overhead area identical in the entity-specific and fairvalue conditions. In addition, both conditions include a 9%risk adjustment factor.

Although the liability amounts are different for the entity-specific and fair value conditions, they result in the same per-centage earnings increases from 2007 through 2009. That is,if the lower amount is chosen (entity-specific $8.2 million;fair value $10.4 million), the resulting earnings increases

from 2007 through 2009 are 105%, 106%, and 108%, respec-tively. Alternatively, if the higher amount is chosen (entity-specific $9.0 million; fair value $11.5 million), the resultingearnings increases from 2007 through 2009 are 105%, 105%,and 110%, respectively. As discussed in the next section, in2009, an earnings increase of 10% over 2008 results in aperformance-based cash bonus, which can only be achievedby choosing the higher of the two liability amounts (entity-specific $9.0 million; fair value $11.5 million). Therefore,because the bonus is based on the percentage increase inearnings rather than the dollar amount of earnings resultingfrom the liability, the differing liability amounts in the twoconditions do not affect the direction or magnitude of theresults.

Additional Assumptions

Participants are asked to assume that they are the con-troller of MMH Corporation. It is December 31, 2007, and

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POTENTIAL MITIGATING EFFECT OF BENCHMARKS 73

TABLE 2Fair Value Financial Information

Assume that you are the controller of MMH Corporation and that MMH will use its own internal resources (labor, materials, overhead) to tear down thesupport facility.

It is December 31, 2007, and for external reporting purposes you must decide on the initial amount of the ARO liability for the support facility describedabove. You are deciding between two amounts: $10.4 million (staff recommendation) and $11.5 million.

Your staff, which is experienced in calculating measurements of this type, provided the following details related to its recommendation for a $10.4 millionfair value measurement of the liability:

Cash Flow Scenario

($000)Component

A B C Total

MMH’s estimated cash flows for labor, materials, and overhead. $7,909 $9,006 $10,661Probability of scenario .333 .333 .333Probability-weighted estimated cash flows $2,610 $2,972 $3,518 $9,100Adjustment for market amounts different from entity-specific amounts. 365 416 493 1,274Subtotal $2,975 $3,388 $4,011 $10,374Profit margin 327 373 441 1,141Subtotal $3,303 $3,761 $4,452 $11,515Adjustment for risk (9%) $1,036Total expected cash flows $12,552Fair value of ARO liability $10,420

The $10.4 million liability would result in the following financial statement results:

ARO liability $10.4 million(Amounts in $millions) 12/31/07 12/31/08 12/31/09Estimated earnings before ARO-related items 60.0 $70.0 $72.0Effect of ARO on earnings (interest and depreciation) N/A (6.2) (6.3)Estimated gain at settlement 3.4Earnings net of ARO items $60.0 $63.8 $69.1Earnings trend over previous year after ARO items 105% 106% 108%Debt-equity multiplier 1.8 1.9 1.8

You are considering whether you can increase the $10.4 million liability to $11.5 million, which would result in a significantly higher gain at settlement andthe following financial statement results:

ARO liability $11.5 million(Amounts in $millions) 12/31/07 12/31/08 12/31/09Estimated earnings before ARO-related items $60.0 $70.0 $72.0Effect of ARO on earnings (interest and depreciation) N/A (6.8) (7.0)Estimated gain at settlement 4.7Earnings net of ARO items $60.0 $63.2 $69.7Earnings trend over previous year after ARO items 105% 105% 110%Debt-equity multiplier 2.0 2.1 1.8

for external reporting purposes they must decide on the initialamount of the ARO liability for the support facility describedabove. In all conditions, it would be personally advanta-geous for participants to choose the higher of the two liabilityamounts. In 2009, the higher amount produces a larger gainon settlement resulting in a 10% increase in earnings over2008, which triggers a performance-based bonus that wouldcomprise a significant part of their overall compensation.However, selecting the higher amount would simultaneouslyplace MMH in default on its line of credit at the bank, as thedebt-equity multiplier would meet or exceed its limit of 2.0.Participants were further informed that the selection of eitherARO amount would not affect cash flows or income taxes,and that the liability would be material to MMH’s financialstatements taken as a whole.

Dependent Measures

Participants are deciding between two amounts for theARO liability in the entity-specific condition ($8.2 millionand $9.0 million) and in the fair value conditions ($10.4 mil-lion and $11.5 million). Participants were asked to indicatethe likelihood that they would recommend the lower amountand higher amount. Both likelihoods needed to sum to100.

Results

Participants

A total of 86 managers, each representing a different com-pany and possessing considerable finance and accounting

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experience, participated in the study. There were 15 femaleand 71 male managers in the sample. The mean (standard de-viation) age was 47.58 (8.46). The analysts’ mean (standarddeviation) years experience in business was 21.06 (7.62), andyears experience in finance and accounting was 19.91 (7.63).There were 56 chief financial officers and 30 chief accountingofficers in the sample. Of the 86 managers, 57 were certifiedpublic accountants. Each participant self-described the sizeof his/her company relative to other companies in his/her in-dustry (the options were: very small, small, medium, largeor very large); there were 17 (19.8%) medium, 43 (50.0%)large and 26 (30.2%) very large companies. The distribu-tion of gender, age, years business experience, years financeand accounting experience, job position, public accountantcertification, firm size and the three seminars were not signif-icant (all p-values > .50) across treatment conditions; hence,the randomization of treatments to participants was deemedsuccessful.

Manipulation Check Items

All participants correctly indicated whether the measure-ment of the ARO was based on fair value or entity-specific.Participants in the entity-specific (fair value) treatments alsoaccurately noted whether there was an internal cost pro-jection (active exchange market) for the ARO liability. Allparticipants properly recognized the following constant as-sumptions: choosing the higher of the two ARO liabil-ity amounts would result in a 10% increase from 2008 to2009 earnings, which would trigger a 2009 cash bonus;the cash bonus would constitute a significant part ofthe manager’s 2009 compensation; choosing the higherARO liability would result in a debt-equity multiplier of2.1 in 2008, which would place MMH in technical de-fault on its bank line of credit; and the difference be-tween the higher and lower ARO liability amounts is con-sidered material to the financial statements taken as awhole. Accordingly, the manipulation checks were deemedsuccessful.

In addition, in the entity-specific (fair value) condi-tions we asked participants the extent of discretion theybelieved they had over changing the staff’s recommenda-tion, regardless of whether the cost management depart-ment had prepared its projections for this liability (therewere exchange markets for the assumption of ARO liabil-ities). We asked this question because we wanted to de-termine whether participants felt they could, if desired,select a different liability than that recommended by theexperienced staff. On a scale of 1 (no discretion) to 9(total discretion), the mean (standard deviation) responseacross all participants was 8.28 (1.02), and the means werenot significantly different across treatment conditions (F= 0.24, p = 0.84). Hence, all participants believed theywere afforded considerable discretion to change the staff’sestimate.

Preliminary Testing

We ran an initial ANCOVA model, where the dependentvariable reflected the likelihood of recommending the higherARO liability, the independent variables represented mea-surement type (entity-specific or fair value), benchmarks(absent or present), and the interaction term. The possiblecovariates were gender, age, years of business experience,years of finance and accounting experience, job position,public accountant certification, firm size and the five semi-nars. None of the covariates was significant (largest F-valueamongst all covariates [firm size] = 0.59, p > .44); hence,they were not included in hypothesis testing. Descriptivestatistics, ANOVA model results, and multiple pairwise testresults are shown on Table 3, panels A, B and C, respectively.

Hypothesis One

H1 indicates that participants in the fair value conditionwithout a comparable benchmark will be more likely to rec-ommend the higher ARO liability amount (i.e., displaying apropensity to manage earnings) than participants in the fairvalue condition with a comparable benchmark.

As indicated by the ANOVA on Table 3, panel B, bench-mark presence is significant (F = 214.81, p <.01), but thismain effect includes both fair value and entity-specific mea-surements. Hence, to test H1, we compare the following twomeans: fair value with a benchmark (15.23) and fair valuewithout a benchmark (72.09). The results from a t-test (t =−16.45, p <.01) and Scheffe’s multiple pairwise testing in-dicate that the two means are significantly different, therebysupporting H1.

Research Question One

The first research question (RQ1) asks, in the absenceof a benchmark, whether an entity-specific measurementand a fair value measurement are equally prone to earn-ings management. A multiple pairwise comparison of thefour treatment means is presented on Table 3 (panel C). Asindicated, the fair value without a comparable market pricemean (72.09) and the entity-specific without an internal costmanagement projection mean (61.40) are not significantlydifferent. This result suggests that, in the absence of a bench-mark, both measurement approaches are equally prone toearnings management.

Research Question Two

The second research question (RQ2) asks whether bench-marks are equally effective at tempering earnings manage-ment for entity-specific and fair value measurements. Asindicated on Table 3 (panel C), the entity-specific with aninternal cost management projection mean (29.76) is signif-icantly greater than the fair value with a comparable mar-ket price mean (15.23), which suggests that an externallyverifiable benchmark (market price) appears to constrain

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POTENTIAL MITIGATING EFFECT OF BENCHMARKS 75

TABLE 3Likelihood of Recommending the Higher ARO Liability

Fair value without abenchmark

Fair value with abenchmark

Entity-specific without abenchmark

Entity-specific with abenchmark

Panel A: Descriptive Statistics: Mean (Standard Deviation) [Sample Size]27.91 84.77 38.60 70.24

Likelihood of recommending thelower ARO liability

(11.97) (11.18) (15.26) (17.06)

[22] [23] [20] [21]72.09 15.23 61.40 29.76

Likelihood of recommending thehigher ARO liability

(11.97) (11.18) (15.26) (17.06)

[22] [23] [20] [21]

Panel B: ANOVA Results – Likelihood of Recommending the Higher ARO Liability

d.f. MS SS F p

Measurement type 1 79.36 79.36 0.41 = 0.53Benchmark presence 1 41, 982.20 41, 982.20 214.81 < 0.01Measurement x benchmark 1 3, 409.93 3, 409.93 17.44 < 0.01Error 82 16, 026.08 195.44

Panel C: Multiple Pairwise Comparison (Scheffe’s Test at α = .01)

Fair value withouta benchmark

Entity-specific without abenchmark

Entity-specific with abenchmark

Fair value with abenchmark

72.09 = 61.40 > 29.76 > 15.23

Hypothesis One (H1): 15.23 < 72.09 (p <.01).Research Question One (RQ1): 72.09 = 61.40 (p = .11).Research Question Two (RQ2): 15.23 < 29.76 (p <.01).

earnings management relatively more than an internally ver-ifiable benchmark (cost management projection).

DISCUSSION

The current study examines the earnings management poten-tial of entity-specific and fair value measurements for AROliabilities, and studies the effectiveness of comparable bench-marks for both measurement approaches. The experimentalresults suggest that the presence, relative to absence, of anexternally verifiable benchmark significantly tempered po-tential earnings management for fair value measurement. Thefindings also indicate a nonsignificant difference in earningsmanagement between an entity-specific measurement anda fair value measurement, in the absence of a comparablebenchmark. In the presence of a benchmark, although earn-ings management was tempered in both the fair value andentity-specific scenarios, it was tempered relatively more inthe fair value scenario. Research findings suggest that, rel-ative to a fair value measurement with no comparable mar-ket benchmark, an entity-specific measurement combinedwith an internal comparable benchmark appears to be morereliable.

Our study contributes to extant literature related to therelative reliability of fair value measurements. For the most

part, previous studies have been limited to financial itemsand, because they employ an archival approach, are limited toindirect tests of relevance combined with reliability, based onwhether fair value amounts are correlated with stock prices.In general, our study supports prior research that suggests thestrength of fair value reliability is correlated with whether theitem being measured is associated with a comparable marketprice. Thus, for ARO liabilities, both relevance and reliabilityof fair value are at question because of the nonexistence ofmarkets and prices.

Our study also contributes to the body of literature re-lated to earnings management by focusing on an accountingmeasurement that has specifically been identified as a po-tential candidate for earnings management (AAA [2005]).It provides an additional test of the assertion of Nelsonet al. [2002] that managers are more likely to attempt earningsmanagement under imprecise standards relative to more pre-cise standards. Finally, our study incorporates various mea-surements of the same liability and examines the effect ofbenchmarks in an earnings management context, which sim-ulates differences between U.S. GAAP and IFRS.

We acknowledge certain limitations in our study.The participants were provided with limited financialinformation about the case company. Providing them witha more complete set of financial statements could havechanged the results of the study. However, in an experimental

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76 MAZZA, HUNTON AND MCEWEN

setting, limiting the financial information in the case mate-rials allows researchers to reduce the time requirements ofparticipants while at the same time providing more controlover the variables of interest, thereby strengthening inter-nal validity, admittedly at the potential expense of externalvalidity.

With regard to earnings management, participants wereprovided with one incentive (cash bonus plan) and one wayto manipulate earnings to achieve the bonus (choice of AROliability). In reality, managers likely have more incentivesand many options available for achieving earnings targets. Inaddition, with respect to the internal cost management pro-jection, an underlying assumption is that it was an “unbiased”albeit internal benchmark. To the extent there is bias in aninternal projection, it would not be as effective at temperingearnings management as suggested by the study results. Thesize of the company, segregation of internal and external ac-counting functions, and the internal controls associated withinternal budgeting functions could also affect the integrity ofsuch projections.

Our findings suggests that an entity-specific measurement(IFRS) that is accompanied by an internally derived compar-ative benchmark for ARO liabilities is less prone to earningsmanagement and therefore can be considered more reliablethan a fair value measurement (U.S. GAAP) that has no ex-ternally verifiable benchmark. We note that although IFRS isbeing adopted in Canada, Japan, and China in 2011, the U.S.does not plan to adopt IFRS before 2015. Thus, ARO liabili-ties are one area where adoption of IFRS may produce morerelevant and reliable financial statement results. Our find-ings also support the recommendation of the SEC’s PozenCommittee [2008] that the FASB be judicious in issuing newstandards expanding the use of fair value in areas where it isnot already required until a plan is implemented to strengthenthe infrastructure that supports fair value reporting.

The results of this study are important for auditors andregulators in their assessment of Level 3 fair value measure-ments, as they should be aware of the earnings managementpotential inherent in the absence of comparable benchmarks.In addition, the results of our study are important for pol-icy makers, who assert that irrespective of whether there areactive exchange markets, fair value is the most relevant andreliable measurement attribute for nonfinancial assets and li-abilities. We suggest that any discipline gained by a fair valuemeasurement objective, may be lost when there is an absenceof market price benchmarks.

NOTES

1. In addition, under SFAS 143 entities are required torecognize an offsetting asset retirement cost by increas-ing the carrying amount of the related long-lived asset.In periods subsequent to initial recognition, FAS 143requires entities to recognize period-to-period changes

in the asset retirement obligation liability resultingfrom the passage of time (accretion expense) and re-visions in the timing and amount of the underlyingexpected cash flows. In addition, it requires entities torecognize depreciation expense resulting from the sys-tematic and rational allocation of the asset retirementcost.

2. When using present value to estimate either fair valueor entity-specific value, the same techniques are ap-plied to arrive at a single measure that incorporates thefollowing economic components: (a) estimated cashflows; (b) expectations about the variability in timingand amount of cash flows under differing circumstancesand the likelihood of those circumstances; (c) the pricethat marketplace participants demand for bearing theuncertainty inherent in those cash flows; and (d) thetime value of money. In determining these components,the difference between fair value and entity-specificvalue lies in whether the assumptions about estimatedcash flows are those that the market would make (gen-eral) or those that the entity would make (specific).An entity-specific measurement uses the entity’s esti-mates and assumptions, focusing on cash flows real-ized or paid over time, to estimate a value unique tothe entity. In contrast, a measurement designed to es-timate fair value assumes that willing parties exist andcan deal in a marketplace that will clear currently atsome price. Therefore, an estimate based on fair valuewould include marketplace assumptions about cashflows, including profit margins and a marketplace riskpremium.

3. Barth and Landsman [1995] discuss three alternativefair value constructs: (a) entry value is an asset’s ac-quisition price or, if relative prices change, an asset’sreplacement cost; (b) exit value is the price at which anasset could be sold or liquidated; and (c) value-in-use isthe incremental firm value attributable to an asset. Us-ing those fair value constructs, the FASB’s definition offair value is analogous to exit value and its definition ofentity-specific value is analogous to value-in-use. How-ever, the FASB does not view an entity-specific valueas a fair value, as do Barth and Landsman [1995].

4. Barth and Landsman [1995] describe two, not neces-sarily mutually exclusive, types of measurement error:(a) unsystematic error arises from general uncertainty;and (b) systematic error arises from management exer-cising discretion in determining estimates.

5. FEI is a leading international organization of 15,000members, including chief financial officers, controllers,treasurers, tax executives, and other senior financialexecutives. CCR is the financial reporting technicalcommittee of FEI, which reviews and responds to re-search studies, statements, pronouncements, pendinglegislation, proposals, and other documents issued bydomestic and international agencies and organizations.

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6. The experimental materials were stacked in randomorder by the researchers and the seminar leader handedout the materials from the top to the bottom of the stack.

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